How to Fix US Debt Without Hurting Fragile Economy

An ax is scheduled to hit the federal budget Friday: Unless the White House and Congress reach a budget deal by then, automatic cuts will carve $85 billion out of the budget through Sept. 30 and $1.2 trillion over the next decade.

The cuts in defense spending, unemployment benefits and other programs could slow an already struggling economy. And they would leave unaddressed the biggest long-term threats to the government’s finances - rising bills for Medicare and Social Security.

Economists say there’s a better way. Shrinking the federal debt doesn’t have to mean either hurting the economy now or ignoring the spending burdens of the future.

Economists widely agree that policymakers should delay deep cuts such as the ones slated to take effect Friday until the economy has strengthened. But they say lawmakers should come up with a realistic long-term plan to fix the debt as soon as possible. The plan would raise revenue and promote economic efficiency by closing tax loopholes, and it would focus cuts on the health care spending that will rise relentlessly as the vast baby boom generation retires.

In the short term, though, what most worries economists is the threat of deep cuts this year.

The cutting set to start Friday is "haphazard, and cuts good programs and bad. It’s not good budgeting practice," says Mark Zandi, chief economist at Moody’s Analytics.

When a government spends more than it collects in taxes in a year, it runs an annual deficit. Every annual deficit adds to the accumulated federal debt.

For the United States, both numbers look bad. Annual deficits have exceeded $1 trillion the past four years. The federal debt has reached $11.7 trillion, not including money that federal agencies have borrowed from each other, including from the Social Security trust fund. If nothing is done about the long-term budgetary burdens, the debt will reach $19.9 trillion by 2023, according to the Congressional Budget Office.

Efforts to close the budget gap have been stymied by Republicans’ refusal to accept new tax increases and Democrats’ insistence that any spending cuts be matched by tax increases. Democrats are also reluctant to shrink spending on popular entitlement programs such as Medicare and Social Security.

In August 2011, President Barack Obama and congressional Republicans agreed to a setup that was supposed to force a compromise. If they couldn’t reach a deal by Jan. 1, 2013 - a deadline later extended to March 1 - automatic spending cuts would kick in. The thinking: The cuts would be so painful to both sides that they’d come to an agreement. The ax would fall equally on a wide range of domestic programs the Democrats support - from preschool programs for poor children to environmental protection - and on defense spending that Republicans support.

It hasn’t worked. The across-the-board cuts look more likely each passing day.

But economists say the automatic cuts are practically the worst way to attack the federal government’s deficits and debt. Here’s what they advise instead:

- DON’T CUT NOW

The economy has yet to regain full strength more than 3½ years after the Great Recession officially ended in June 2009. Growth has averaged 2.1 percent annually the past three years. That isn’t strong enough to generate healthy job growth. Unemployment is stuck at a high 7.9 percent.

Cutbacks by state and local government have dragged down economic growth the past two years. Deep federal cuts now would worsen things. Macroeconomic Advisers predicts the automatic cuts would reduce economic growth this year to 2 percent from 2.6 percent, wipe out 700,000 jobs and keep unemployment at 7.4 percent or higher through 2014

"We’re right on the edge of what the economy can digest" in spending cuts, Zandi says.

Only two of 31 economists surveyed last week by the Associated Press called for significant spending cuts now. The rest wanted to see deep cuts delayed.

Europe’s experience shows that hasty budget cuts can be counterproductive when economies are weak. Despite slashing spending and raising taxes, Britain, Spain, Portugal and Italy have all seen their debt burdens rise. Their economies shrank because of the painful austerity measures, which meant their debts grew as a percentage of gross domestic product, or GDP, the broadest measure of economic activity.

The best medicine for swollen federal debts, experts of all political persuasions agree, is stronger economic growth. A healthy economy means more people are working, earning money and paying taxes; and fewer are collecting federal benefits such as unemployment checks and food stamps.

Already, a slowly improving economy has helped whittle the United States’ federal deficit. The deficit peaked at $1.4 trillion at the depths of the Great Recession in 2009 and has been falling ever since. The Congressional Budget Office says it will fall to $845 billion this year if the automatic cuts take effect.

- REFORM THE TAX CODE

The U.S. tax system is riddled with tax breaks that benefit everyone from homeowners to oil and gas companies. These tax breaks cost the Treasury $1.3 trillion last year, according to the nonpartisan Tax Policy Center.

Economists say the loopholes warp the economy by diverting investment away from projects that make economic sense and into those that are subsidized by tax breaks. Economists and budget analysts say the government could raise revenue and improve economic efficiency by ending some of the tax breaks.

Among those calling for ending or scaling back most tax breaks are the Bipartisan Policy Center and former Republican Sen. Alan Simpson and former Clinton administration official Erskine Bowles, co-chairmen of a presidential commission assigned to find ways to reduce the federal debt.

Of course, getting lawmakers to end the tax breaks won’t be easy. The loopholes are popular. And Congressional Republicans are currently refusing any budget deal that raises tax revenue by closing loopholes.

- TARGET ENTITLEMENT PROGRAMS

The most serious threat to the federal government’s finances is America’s aging population. As baby boomers have begun to shuffle into retirement, they are tapping Medicare health care benefits and collecting Social Security.

The CBO sees federal deficits falling through 2015 as the economy improves and the automatic budget cuts reduce spending. But then the deficits start rising again inexorably because of higher health care spending and rising interest payments on the federal debt. The debt will near $20 billion by 2030 if nothing is done, according to the CBO.

Many Democrats have resisted efforts to slow the growth of Medicare and Social Security. Economists say Democrats will have to accept the reality that the government can’t keep spending at its current pace indefinitely.

America spent more than $8,200 per person on health care in 2010. That’s the most of any country and more than 50 percent higher than No. 2 Norway’s $5,388 per person.

The automatic spending cuts largely leave health care and Social Security spending alone. Instead, they zero in on the rest of the federal budget - so-called discretionary programs - including defense spending. But the 2011 budget agreement already took an ax to discretionary programs. The White House says they are already scheduled to fall to 5.7 percent of U.S. GDP by 2017 - the lowest level in budget records dating back to 1962. Discretionary spending accounted for nearly 37 percent of the $3.8 trillion the federal government spent last year; so-called mandatory programs, including Social Security and Medicare, accounted for 61 percent.

"By far the preferable policy," Macroeconomic Advisers says, "is a credible long-term plan to shrink the deficit more slowly through some combination of revenue increases within broad tax reform, more carefully considered cuts in discretionary spending, and fundamental reform of entitlement programs."

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